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Economics 101: Mechanics behind fiscal union and why it can work for the GCC

In a fiscal union, the member countries surrender their tax revenues to a central authority, which then spends the money, possibly via the intermediation of member governments.

What is fiscal union and does it solve “moral hazard” issues in single currencies?

A former president of the European Commission, Jacques Delors, has been finger-wagging about the need for fiscal union for about 20 years. Will it solve the euro zone’s problems?

In a fiscal union, the member countries surrender their tax revenues to a central authority, which then spends the money, possibly via the intermediation of member governments. A fiscal union typically involves harmonised taxes across members, to avoid complaints about differential treatment.

Practically speaking, a combination of fiscal and monetary union strips member governments of much of their power, although there is some variation. For example, the members of the US are involved in fiscal quasi-union, as the federal government collects a large proportion of taxes, as well as contributing a large proportion of public spending. However, state governments retain the right to levy taxes and pass their own laws. In contrast, two different cities in England are part of a much stricter fiscal union: municipalities have comparatively little latitude in their local affairs.

In the last article, we learnt that single currency members face a diminished cost of fiscally irresponsible behaviour, as most of the cost is borne by other member states (“moral hazard”). Strict fiscal prudence rules (“convergence criteria”) are a theoretically valid solution that fails in practice because enforcing adherence is politically very difficult: nobody likes belt-tightening, especially during recessions, and convergence criteria will appear to citizens as pseudo-colonial external interference in internal affairs, giving their governments a pretext for rejecting them.

Fiscal union addresses this by constitutionally taking most fiscal affairs out of the member governments’ hands permanently. Moreover, the supranational authorities are constitutionally charged with operating in the interests of the entire union, eliminating the problem of governments free-riding on the fiscal discipline of their currency partners in the monetary union. That is one reason why Mr Delors and his fellow Europhiles have been angling for fiscal union for many years.

Will it work? In some cases, such as the GCC, it may well work. But first let us understand why it is likely to fail for the euro zone.

Together, monetary and fiscal union constitute a de facto poli­tical confederation. Europe’s peoples have an affinity for their brethren, but not enough to become their fellow citizens. The countries have a strong sense of national pride, rich histories and widely divergent cultures, especially when one starts comparing north to south, and east to west.

The project was initiated in an effort to end centuries of bloody conflict that culminated in the two worst wars in history – an admirable goal. However, seeking a method that prevents mutual annihilation is very different to loving each other enough to become a single country. Many countries that have had a history of conflict have successfully ceased without needing to politically merge, such as France and the UK, or Portugal and Spain (both sets of conflicts ended long before the European project).

If a fiscal union is imposed upon the euro zone, the economic stability will be a mirage, as political discontent will eventually lead to calls for secession and the possible collapse of the entire European project. Via a combination of domestic and European Parliamentary elections, citizens of the EU’s member states have made it clear to policymakers that European integration needs to slow down, rather than speed up.

In the GCC, fiscal union could work. While the governments have their disagreements, the cultural foundations for a political union are sound: common language, religion, tribal ties and traditions. The German and Italian unifications of the 19th century were partially the result of people rejecting foreign imperialism. The Middle East has always attracted the attentions of would-be hegemons, and in the present climate that could be enough to make GCC fiscal union work.

Omar Al Ubaydli is the programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University in the US.

We welcome economics questions from our readers via email (omar@omar.ec) or tweet (@omareconomics)


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Updated: November 19, 2016 04:00 AM

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